Inverted Yield Curve

NEWS ALERT March 28, 2022, 9:55 a.m. EDT: The spread between five-year notes and 30-year bonds inverted for the first time since 2006 when five-year yields rose to 2.63%.

What Is an Inverted Yield Curve?

An inverted yield curve describes the unusual drop of yields on longer-term debt below yields on short-term debt of the same credit quality.

Sometimes referred to as a negative yield curve, the inverted curve has proven in the past to be a relatively reliable lead indicator of a recession.

Key Takeaways

  • The yield curve graphically represents yields on similar bonds across a variety of maturities.
  • An inverted yield curve occurs when short-term debt instruments have higher yields than long-term instruments of the same credit risk profile.
  • An inverted yield curve is unusual; it reflects bond investors' expectations for a decline in longer-term interest rates, typically associated with recessions.
  • Market participants and economists use a variety of yield spreads as a proxy for the yield curve.
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Inverted Yield Curve

Understanding Inverted Yield Curves

The yield curve graphically represents yields on similar bonds across a variety of maturities. It is also known as the term structure of interest rates. For example, the U.S. Treasury daily publishes Treasury bill and bond yields that can be charted as a curve.

Analysts often distill yield curve signals to a spread between two maturities. This simplifies the task of interpreting a yield curve in which an inversion exists between some maturities but not others. The downside is that there is no general agreement as to which spread serves as the most reliable recession indicator.

Usually, the yield curve slopes upward, reflecting the fact that holders of longer-term debt have taken on more risk.

Inverted Yield Curve
Inverted Yield Curve. Image by Julie Bang © Investopedia 2019

A yield curve inverts when long-term interest rates drop below short-term rates because investors expect short-term rates to decline in the future, typically as a result of impaired economic performance. Such an inversion has served as a relatively reliable recession indicator in the modern era. Because yield curve inversions are relatively rare yet have often preceded recessions, they typically draw heavy scrutiny from financial markets participants.

An inverted Treasury yield curve is one of the most reliable leading indicators of a recession.

Choose Your Spread

Academic studies of the relationship between an inverted yield curve and recessions have tended to look at the spread between the yields on the 10-year U.S. Treasury bond and the three-month Treasury bill, while market participants have more often focused on the yield spread between the 10-year and two-year bonds.

Federal Reserve Chair Jerome Powell said in March 2022 he prefers to gauge recession risk by the difference between the current three-month Treasury bill rate and the market pricing of derivatives predicting the same rate 18 months later.

Historical Examples of Inverted Yield Curves

The 10-year to 2-year Treasury spread has been a generally reliable recession indicator since providing a false positive in the mid 1960s. That hasn't stopped a long list of senior U.S. economic officials from discounting its predictive powers over the years.

In 1998, the 10-year/2-year spread briefly inverted after the Russian debt default. Quick interest rate cuts by the Federal Reserve helped avert a U.S. recession.

While an inverted yield curve has often preceded recessions in recent decades, it does not cause them. Rather, bond prices reflect investors' expectations that longer-term yields will decline, as typically happens in a recession.

In 2006, the spread inverted for much of the year. Long-term Treasury bonds went on to outperform stocks during 2007. The Great Recession began in December 2007.

On Aug. 28, 2019, the 10-year/2-year spread briefly went negative. The U.S. economy suffered a two-month recession in February and March 2020 amid the outbreak of the COVID-19 pandemic, which could not have been a consideration embedded in bond prices six months earlier.

What Is a Yield Curve?

A yield curve is a line that plots yields (interest rates) of bonds of the same credit quality but differing maturities. The most closely watched yield curve is that for U.S. Treasury debt. 

What Can Inverted Yield Curve Tell an Investor?

Historically, protracted inversions of the yield curve have preceded recessions in the U.S. An inverted yield curve reflects investors' expectations for a decline in longer-term interest rates as a result of a deteriorating economic performance.

Why Is the 10-Year to 2-Year Spread Important?

Many investors use the spread between the yields on 10-year and 2-year U.S. Treasury bonds as yield curve proxy and a relatively reliable leading indicator of recession in recent decades. Some Federal Reserve officials have argued a focus on shorter-term maturities is more informative about the likelihood of a recession.  

The Bottom Line

A yield curve that inverts for an extended period of time appears to be a more reliable recession signal than one that inverts briefly, whichever yield spread you use as a proxy.

But recessions are fortunately a rare enough event that we haven't had enough to draw definitive conclusions. As one Federal Reserve researcher has noted, "It's hard to predict recessions. We haven't had many, and we don't fully understand the causes of the ones we've had. Nevertheless, we persist in trying."

Article Sources

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